As stated previously, I will be providing some educational information for anyone who is interested in reading my posts. In this one I will be covering how P/E ratio’s can be a good first step to finding Value Investing opportunities.
One of the basic ideas behind investing is that earnings tend to drive stock prices, the better a company’s earnings the better the return that is seen on the growth of their share price. Or more accurately the share price tends to increase based off of expected future earnings. As such the Price per Earnings ratio is often a very good indicator of a “good buy” from a valuation standpoint.
The Price to Earnings ratio is a valuation comparison of the company’s current market price (per share) divided by its Earnings per Share (EPS). The previous 4 quarters earnings are typically used, although sometimes it is calculated using the expected earnings of the next 4 quarters, or the previous two quarters and the expected earnings of the next two quarters. The P/E ratio is often also referred to as the companies “Price Multiple” or “Earnings Multiple”.
Of course a lot of people feel that the theory that the markets are extremely efficient and that everything is priced into the share price will argue that if this ratio is low that there is probably a reason for it. However the markets are not always as efficient as what is assumed and sometimes stocks will fall out of favor and will lag behind in their market value as compared to their true value. The primary issue with this stance is the fact that the business and investment media tends to sensationalize things the same way that the normal media channels do, as it improves ratings and in-turn sells advertising which is what generates their revenue. This is where utilizing P/E ratio comes in handy, as it is one of several indicators of how a company is currently valued by the market, and as with any Value Investing your goal is to find companies that are valued by the market at substantially less than the company’s true value.
As with any indicator, this needs to be looked at with other factors in mind as well. For example, while the P/E ratio can indicate that a company that has a low current market price as compared to its earnings, one must also look at other factors to see if there is a reason behind this low value. Once in a while a company’s share price will fall due to bad news that has little bearing on its earnings (either current or expected future earnings). While other times there is something that will affect the companies future earnings in a very negative way, in which case it may be better to avoided it if the future effect of the bad news on earnings is accurately represented by the current price. But then there are times when the bad news results in panic, which can drive the share price lower than what is reasonable for the future effects on earnings, and this is often the case with some of the best potential value investments, as often times the management will then work very hard to try to improve things and strengthen the company while the share price drops to every low levels. These often result in great buys that will result in improvements that will then result in quick returns for those who are willing to take the risk. However, as with any investing, there are still risks, as if the company can’t improve or the negative effects on future earnings continue then the value could fall even further, which is often referred to as a “falling knife”. The key is to determine which “falling knives” are price appropriately and which have had their share prices driven unreasonably low and will recover relatively quickly.
Another issue with P/E ratio, as with any sort of financial ratio, is that the P/E of the company being considered should be compared with others that are in the same sector and if possible within a specific sub-category within that sector, as not all sectors will have the same general trend when it comes to P/E ratios. For example, as of this writing Metal Mining was seeing an average P/E ratio of 13.0 while in the Software and Programming industry the average was 19.0. There is also the issue of the price tending to be relative to the expected future earnings or expected earnings growth. As an example of this, often times a company that has negative earnings growth will often (although there are certainly exceptions to this) have P/E’s of between 8 and 12 or thereabouts, companies that have a small or modest earnings growth will often be at a 15-20 range, while companies that are thought of as having a very high rate of earnings growth are often expected to have P/E’s in the low 20’s to the mid 30’s if they are also extremely profitable. However, these do vary considerably from one day to the next. These are the reasons that you should compare the company to its peers, as other companies in the same line of business should generally have somewhat similar P/E ratio’s, although you will still see a moderate amount of variation even within such groups.
Thus while a company’s P/E ratio can be a good indicator of it being a potential good investment, one must dig deeper into the company to truly know what its value is. As the old saying goes, “Knowledge is power!” It does serve as one of two very good starting points when searching for value investments, but should only signal that the company is worth evaluating further. As with any investment, one should do their homework and know what they are getting into and should never invest what you can not afford to loose, as sometimes even the best of companies can fail. I will discuss more about other information that should be looked at from a Value Investing standpoint in future articles.